There is a growing danger that threatens the financial security of retirees who should have been relatively insulated from the market setbacks of recent years: people with defined-benefit pensions. Unlike people in 401(k) plans and other defined-contribution vehicles, people with defined-benefit pensions don't see their retirement benefits bounce up and down with the market. Instead, their benefits are guaranteed by their former employers. With the corporate community having largely abandoned defined-benefit pensions, it is often government employees, including military personnel, who are still covered by these plans. The threat comes in the form of pension advance loans, which often employ predatory terms that can greatly reduce the value of a retiree's benefits.
What are pension advance loans?Pension advance loans provide an upfront amount in exchange for payment from the retiree's future pension benefits. While that may make sense in some situations, one general problem is that it feeds into the common tendency of Americans to overspend now at the expense of their financial futures. What's worse is that pension advance loans often charge exorbitant interest rates. While today's mortgage rates are down around 3.5 percent and bank rates on deposits are even lower, an investigation by The New York Times found that after factoring in all costs, the pension advance loans surveyed charged effective interest rates between 27 and 106 percent. At that cost, pension advance loans are not just a case of sacrificing the future for the sake of the present -- they are pretty much like throwing money away.
What to consider before you take out a pension advanceHere are five things to consider before you agree to a pension advance loan:
- What will happen to your financial needs as you age? Unless you have reason to believe your expenses will be considerably lower in the future than they are now, you should not give up future benefits for the sake of current spending.
- Are you borrowing for short-term or long-term benefit? This is the difference between using money for something that will benefit your for years to come, or splurging on something you may regret for years to come.
- What is the effective interest rate? Calculate how much you'll have to pay in the form of future benefits compared to how much you'll get now. At a time when even high-yield savings accounts are only paying about 1 percent, and even most credit card rates are in the teens, paying 20 percent or more for a pension advance loan is hard to justify.
- Did you plan on leaving an inheritance? As people age, they start to think not just about their own future, but about future generations. If you had planned to leave any money behind, hanging onto your retirement benefits rather than borrowing against them may by your last chance to accumulate some savings.
- Can you plot another course before it's too late? People often resort to pension advance loans because they are in a bind. Before you get into that situation, work on maintaining a lifestyle that your benefits can afford.